KLK reported poor 1HFY23 results. Even after adjusting for a  RM170m impairment charge by UK associate, 1HFY23 CNP still came in at only 33% of our, and 34% of consensus, full-year  estimate. Both upstream and downstream were generally weaker,  for both 2QFY23 and 1HFY23. Higher cost crimped upstream earnings while poor demand dampened downstream earnings.  Downgrade FY23-24F CNP by 33% and 11%, respectively. TP is cut  by 9% from RM27.00 to RM24.50 but maintain OUTPERFORM. KLK  remains our integrated pick for the sector.

Weaker-than-expected 1HFY23. Reported NP for 2QFY23 and  1HFY23 were pulled down by £126m (effectively RM170m at KLK) of goodwill write-down incurred by 27%-owned associate, Synthomer, for a newly acquired adhesive unit. The bulk of the variance between  reported NP and our CNP for 2QFY23 is thus the net-off between  RM127m of gains against this impairment. 2QFY23 CNP of RM234m (- 56% QoQ, also -56% YoY) was pulled down by weaker FFB output on  QoQ basis and weaker CPO price on YoY basis. Downstream segment’s refining and oleo-chemicals units suffered weaker demand.  Net gearing edged down from 47% in Dec to 46% in March. An interim dividend of 20.0 sen (flat YoY) was declared for 1HFY23.

Upstream should recover in FY24. 2023 edible oil supply is expected to recover but not as much as earlier estimated due to poor Argentinian soyabean harvest. Demand is also set to recover as buyers replenish inventory, post-Covid reopening in China and growing biofuel demand. No sizeable global supply surpluses are thus expected for 2023 with flattish inventory going into 2024. In view of the weaker 1HFY23 CPO  price average, we are toning down FY23-24F CPO price from RM3,800  to RM3,700 per MT. Rising production cost is another challenge but softer fertiliser and fuel costs suggest cost inflation could be topping out in the next 3-6 months. Wages are still inching up, though contained to  some degrees only by higher FFB output.

Downstream slowdown is expected, which can provide opportunity to expand. A major global oleo-chemical player, KLK has been supplying renewable chemicals to personal care, cosmetics,  lubricants, polymer and industrial players since the 1990s. It started focusing more on better-margin specialty oleo-chemicals about 15  years ago. A month ago, KLK took control of Temix Oleo, an Italian biodegradable lubricant (and cosmetic) specialist for RM300m-RM400m with yearly profit of RM30m-RM60m. Further downstream expansion is possible as softer economic outlook may dampen chemical demand while some players struggle on energy supply and cost dynamics in Europe. Moreover, upstream expansion may prove expensive as valuation for estates should stay high on firm CPO prices.

Dividends. With no strict dividend policy, its 10-year median/mean  NDPS is at 50.0 sen/60.0 sen. The latest 20.0 sen interim dividend falls within our full-year annual NDPS estimate of 50.0 sen for FY23-24.

Maintain OUTPERFORM. Downgrade FY23-24F CNP by 33% and 11% respectively. Accordingly, TP is trimmed from RM27.00 to RM24.50  based on 15x FY24F PER which is in-line with the historical rating for integrated players, and a 5% premium for its 4-star ESG rating. Given its good track record, defensive balance sheet and expansionary mode,  KLK remains our sector pick. Risks to our call include: (i) weather impact on edible oil supply, (ii) unfavourable commodity prices fluctuations, and (iii) production cost inflation.

Source: Kenanga Research - 25 May 2023